Notes From Underground: July 5TH PROVIDES THE FIREWORKS

Yesterday, the United States celebrated the victory of political freedom from the FISCAL TYRANNY of 18th century England. One day soon maybe we will be free from the financial REPRESSION of the FED … so sayeth the U.S. BOND MARKET.

On Tuesday night, the RBA (Reserve Bank of Australia) moved to maintain its cash lending rate at 3.5%. The Aussies were cautious in their statement and cited slower growth in China being a concern but were willing to wait for further confirmation before any more easing. Governor Glenn Stevens seemed to be willing to wait because Australia and other capital markets have been the recipient of lower long-term interest rates due to the uncertainty in European capital markets. “While capital markets remain open to corporations and well-rated banks, low appetite for risk has seen long-term interest rates faced by highly rated sovereigns, including Australia, decline to exceptionally low levels.”

Bottom line is that the EU’s continuing woes have led to diminished risk premiums in high quality capital markets, thus giving the RBA a window of time on interest rates. Tuesday the AUSSIE 10-YEAR YIELD WAS 3.16% as the OVERNIGHT/10-YEAR CURVE IS INVERTED, although TWO-YEAR AUSSIE YIELDS ARE 2.55%.

At 6am Chicago time, the Bank of England will ignite the beginning of much financial data. The BOE is expected to maintain its lending rate at 0.50% while increasing the QE program by 50 BILLION POUNDS. I BELIEVE THAT THE QE WILL INCREASE THE CONSENSUS AMOUNT, RISING TO 375 BILLION, BUT IT WOULD NOT SURPRISE ME TO SEE THE BOE CUT THE OVERNIGHT RATE BY 25 BASIS POINTS TO 0.25%. The reason this is possible is because the BOE‘s Governor Mervyn King was defeated at the last meeting in his quest to increase the QE program and all British data since the last MPC meeting has been tepid. Imagine if Ben Bernanke had lost a vote at the FED and then had his projections of economic weakness confirmed.

Also, Sir Mervyn is very aware of the mounting problems in the U.K.’s largest trading partner, the EU, and will do everything in his power to keep the POUND from rising against the troubled EURO. The BRITS are in a similar bind to the SWISS as they don’t want to be the EURO‘s haven outlet. Granted, the EUR/GBP cross is nowhere near historic lows so the SWISS contrast is not perfect, but Britain has taken an austerity path that has caused its economy to weaken. A 25 basis point cut by the MPC will catch the market off guard as 54 out of 52 economists predicted just a QE add.

Forty-Five minutes later the ECB will announce its intentions. Consensus is for a 1/4 point cut from 1.00% to 0.75%. Some analysts are looking for a 50 BASIS POINT CUT but this is a very difficult call as President Draghi has already raised the ire of the BUNDESBANK and may not want to push too hard with all the attention that has recently been focused on the ECB. There were several articles on Tuesday and Wednesday discussing the idea of the ECB and the ESM not taking any increases in government-guaranteed bank bonds. The release from the ECB maintained that current levels of collateralized bank bonds with a sovereign guarantee would be held a current levels. The news stories covering this release were confusing as the FT reported that  “banks borrowing from the ECB must pledge collateral in return and bank’s own bonds would not be eligible without government guarantees.”

So, as usual with Europe confusion reigns, thus making any prediction about ECB intentions very difficult. Adding to the problem is the increasing amount of anti-EU rhetoric in the German press. Even mainstream media are challenging the idea of infinite German transfer payments and guarantees to the absorb the debt of the peripherals. Spiegel Online published a piece, “HOW THE EURO ENDANGERS THE GERMAN ECONOMY.” The battle over Germany bailing out EUROPE is now on the boil in domestic politics. Chancellor Merkel’s political backbone will be continually tested as German elections are called for the Autumn of 2013. So with the COLLATERAL RULES IN FLUX WILL THE ECB DO MORE WITH INTEREST RATES AS BOW TO THE POWER OF MARKETS?DOES DRAGHI HAVE THE FORTITUDE TO GET AHEAD OF MARKET ANGST?

***As markets move on from the June 29 EU SUMMIT, it will be important to watch EUROPEAN BOND MARKETS as a barometer of European policymakers’ success in improving the borrowing capabilities of the most heavily stressed sovereign borrowers. My readers have known that the ITALIAN/BUND 10-YEAR DIFFERENTIAL HAS BEEN AN IMPORTANT INDICATOR FOR OVER TWO YEARS AND IT REMAINS SO TODAY. Until recently the ITALIAN BOND FUTRES WERE THE ONLY ALTERNATIVE TO BUND FUTURES AND THUS THE ITALIAN BOND MARKETS BECAME THE CONDUIT FOR ANY INVESTOR LOOKING TO HEDGE DEBT EXPOSURE. NOW THE FRENCH HAVE LISTED A 10 YEAR NOTE FUTURE (symbol is FOAT on CQG)–it was listed on April 16–and SEPTEMBER is now the most active contract. The FRENCH debt situation is deteriorating and today President Hollande announced a 7.2 BILLION EURO TAX INCREASE AIMED MOSTLY AT THE WEALTHY.

The French economy is weak and yet Hollande is looking to punish the wealthy and corporate sector.France is in a very difficult situation as its public sector already consumes 54% of its GDP. If the French austerity promotes a further economic slowing, the BUND/FRENCH spread is going to widen. Tuesday the GERMAN/FRENCH spread closed at 101 BASIS POINTS so that will be our indicator going forward.

Also watch the FRENCH/IRISH 10-year differential as an indicator of any new stress on French debt. The Irish 10-year does not have a futures contract so readers will have to seek other venues for levels (BLOOMBERG.COM) but this spread becomes important. Irish BOND RATES HAVE DROPPED SINCE THE BRUSSELS SUMMIT AS INVESTORS HAVE GIVEN THE EU’S PLEDGE TO SEPARATE BANK AND SOVEREIGN DEBT LIABILITY.

THIS MOVE IS ASSUMED TO BE A RELIEF FOR IRELAND AS THE IRISH PLACED ITS SOVEREIGN STATUS IN JEOPARDY BY RUSHING TO BACKSTOP ITS BANKS. The IRISH AUTHORITIES are planning to test this theory by bringing a new BOND offering to market very soon. If FRENCH 10-years become vulnerable and the IRISH situation improves, the FRENCH/IRISH NOTE SPREAD OUGHT TO NARROW DRAMATICALLY  much food for thought in the EUROPEAN SOVEREIGN DEBT MARKETS.


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2 Responses to “Notes From Underground: July 5TH PROVIDES THE FIREWORKS”

  1. arthur Says:

    Draghi also said he doesn’t see deflation in any Euro country.

  2. yra harris Says:

    Of course he is sequestered in the ivory halls of frankfurt–he sees only what he needs to see–i guess he hasn’t been to the peripheries of late

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